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2nd Quarter 2012 Commentary - ASTON/Barings International Fund

2nd Quarter 2012

International equity markets had a poor quarter, with the Fund’s MSCI EAFE Index benchmark dropping more than 7%. Every region in the index fell in absolute terms, with Europe ex-UK the worst performing region as another round of the eurozone fiscal crisis hit during the period. Japan followed as the next weakest region of the benchmark, with the United Kingdom delivering the best returns, though it still declined by 4%. On a sector level, Technology and Materials were the worst performing areas with each dropping double-digits. Healthcare was the best performing sector, and the only one to post a gain during the quarter in returning 1%.

The Fund only slightly underperformed the benchmark during the quarter owing to asset allocation on the regional and sector levels. An underweight stake in continental Europe did not keep pace with the index during the June market rebound. Emerging Markets and Japan also lagged in June as international stocks bounced back strongly after confidence in the fiscal situation in Spain was restored. An overweight position in the weak Technology sector and an underweight in more defensive-oriented Consumer Staples detracted from returns, which was only partially offset by an overweight stake in Healthcare.

Positive Stock Selection

Stock selection by sector and by region was slightly positive overall. Good stock selection in the Materials sector came from holdings in agricultural commodity companies and precious metals miners. Stock selection within Industrials and Europe ex-UK also contributed positively. This was offset only somewhat by weak stock selection in Energy.

A reserve write-down from oil and natural gas exploration and production company Niko Resources and a weak performance from uranium miner Paladin Energy were the main factors in the poor performance in Energy. Niko announced a significant downgrade in June of its estimates of the reserves it holds in a particular exploration block in India. As the company undertook further drilling on the block, it was found that the well logs produced data at odds with the original geological model that pointed to a larger reservoir outside of the existing production area.

In terms of positioning, there were only a few changes to the portfolio, the most notable being the sale of UK oil major BP to fund an increase in Royal Dutch Shell. BP had been a good performer since it was added to the portfolio during the summer of 2010, but we became increasingly concerned about their Russian strategy and the fractious relations between the company and its Russian JV partner. Royal Dutch Shell has been disciplined in their capital spending this cycle and that has led to attractive free cash flow growth for the business.

In addition, we added a holding in UK pharmaceutical company GlaxoSmithKline to the portfolio during the quarter. We think the company is attractively valued with a good pipeline of new products. We have also been impressed with Glaxo's increasingly disciplined capital allocation and focus on returns.

Ongoing European Crisis

International equities were unable to follow through on the strong performance seen during the first quarter, even with second quarter results flattered by a sharp rally on the last day of the period. There were a number of drivers of the recent weak equity market performance. The first, and most prominent one, was the ongoing European crisis, the depth and breadth of which grew on a number of fronts in the quarter. European economies, particularly in peripheral Europe, continued to weaken. Unemployment in Spain and Greece is approaching 25%, with youth unemployment significantly higher. This cannot continue without social unrest ensuing.

The knock-on effect has been to undermine fiscal revenues. Government budget deficits across Europe have been widening. For the weaker economies this has led to ballooning interest rate costs. All eyes remain on Spain and Italy where 10-year interest rates have risen over the quarter to the current levels of 6.5% and 5.8% respectively. With the economic growth outlook bleak these borrowing costs are unlikely to be sustainable.

What was disappointing during the period was that the reduction in Spanish and Italian yields brought about by the Long Term Refinancing Operation (LTRO) did not hold. Part of the reason for this has been the nexus of European sovereigns and European banks. The weakening peripheral European economies have made investors aware of the weak solvency positions of peripheral European banks. Peripheral European countries are expected to backstop their banking systems and this has therefore increased the sovereign default risk and contributed to rising peripheral bond yields.

As grim as all this is, on the final day of the quarter the communique coming out of the European summit did provide a ray of hope that this nexus might be broken. The Europeans have a general agreement to allow the European Stability Mechanism (ESM) to be used to directly fund bank capital, shifting the burden off of weak peripheral governments.

This does not suddenly get Europe out of the woods. There is much work to be done to get from a general agreement to a formal agreement, and it will take time, which Europe doesn't have a lot of. There is also the issue of the stronger European governments being willing to fund the ESM and effectively take the burden of weak peripheral banks onto their balance sheets. Still, it is a first step toward a longer term solution.

Slowing China

The second driver of the declining international equity markets was the ongoing weakening of the Chinese economy. This is happening on two fronts. One is general weakness in infrastructure spending, particularly focused on the housing market. To us, this looks like a necessary step in the rebalancing of the Chinese economy away from fixed asset investment and toward domestic consumption. We continue to expect weaker demand from China in infrastructure related materials and equipment. The other area of weakness is in manufacturing. Weak global growth is hurting demand for Chinese products. This is particularly being felt with demand from Europe. Thus, the resolution to the European crisis would have knock-on benefits around the world.

We expect the Chinese authorities to continue to ease monetary and fiscal policy, and to direct it toward domestic consumption. We do not expect, however, a spending program similar to what China implemented in 2009. As China progresses toward leadership change later this year there is an increasingly vocal recognition that the 2009 program led to over investment and contributed to China's current economic imbalances.

It’s Not Just About Growth

For many regions of the world it is apparent that economic growth is disappointing and it isn't obvious how this turns around. Equity returns, however, are not only about economic growth. Monetary policy and valuations have a big impact as well. In the current weak economic growth environment, with highly indebted western households and governments, we remain convinced that monetary policy will remain very loose until we see autonomous economic recovery or until the inflation problem becomes acute. Neither of these is apparent right now.

We also believe that the valuations of many, though not all, stocks are quite attractive. The exception we would make is for companies that are apparently cheap but that are operating at peak margins in weakening industries. As margins revert to the mean we feel these stocks will be subject to earnings downgrades. We think companies operating in growth areas where margins are sustainable will perform well under the current loose monetary conditions. Our focus for the portfolio remains to identify stocks operating in these areas, such as Healthcare, where valuations justify the growth outlook.